Should Stock Buybacks Be Banned and Why It Matters

Stock buybacks have been a contentious issue in the world of finance, with some arguing that they're a sign of a company's strength, while others claim they're a way for executives to line their own pockets.

Companies have been buying back their own shares for decades, with the goal of increasing the value of their stock.

In 2018, companies spent over $1 trillion on stock buybacks, a staggering amount that has only continued to grow.

This has led some to question whether stock buybacks are a net positive or negative for the economy, and whether they're being used for the right reasons.

For your interest: Why Are Stock Buybacks Bad

Stock buybacks can be a powerful tool for companies to return cash to shareholders, but they can also lead to serious dangers. Managers often suffer from an overconfidence bias, believing their company is undervalued and that share repurchases at current valuation levels would be a good investment.

Executives tend to believe that their company is undervalued, just like the classic driving example where 80 out of 100 people think they're above average at driving. This overconfidence bias leads managers to buy back shares at the wrong time, when the stock is at or near its peak.

For your interest: Undervalued Stock Definition

Companies typically engage in share repurchases when the firm is doing well and generating excess capital, often when the stock is at or near its peak. This is the opposite of "buy low, sell high", which is the best investment strategy.

In fact, a 2019 study by Fortuna Advisors shows that 64 percent of companies in the S&P 500 had negative buyback effectiveness, implying that a company's buyback return on investment (ROI) was lower than its total shareholder return (TSR).

Here's a breakdown of buyback restrictions by jurisdiction:

Companies must ensure that any buyback is aligned with their long-term strategy, including having adequate liquidity buffers and capital for other needs. This is crucial to avoid poor timing of investment decisions and excess leverage.

Stock buybacks have a significant impact on markets and the economy. Companies that engage in buybacks can artificially inflate their stock prices, making it seem like their financial health is better than it actually is.

Worth a look: Gm Stock Buyback

Research has shown that buybacks can lead to a 5% increase in stock prices, making it a popular strategy for companies to boost their share value. This can be seen as a form of corporate manipulation, where companies prioritize short-term gains over long-term sustainability.

The buyback frenzy has led to a surge in stock prices, but it also creates a false sense of security among investors. Many investors rely on buybacks as a signal of a company's financial health, but this can be misleading.

Companies that engage in buybacks often use debt to finance their purchases, which can lead to increased debt levels and a higher risk of default. This can have a ripple effect on the entire economy, making it more vulnerable to market fluctuations.

The impact of stock buybacks on the economy is a complex issue, but one thing is certain: it can have far-reaching consequences for investors and the market as a whole.

For more insights, see: Bank of America Share Buyback

Stock buybacks can be a great way to boost a company's stock price, as seen in the case of Apple, which used its buyback program to drive up its stock price by 50% in just two years.

By returning excess cash to shareholders, companies can increase the demand for their stock, making it more attractive to investors.

This can be particularly beneficial for companies with a strong track record of profitability, like Microsoft, which has consistently generated high returns on equity.

Buybacks offer a technical capital allocation tool that can be a more attractive alternative to dividends for several reasons. They recycle cash, freeing up "trapped cash" from firms in mature or capital-light industries with limited investment opportunities.

Companies like Apple can invest a lot of money back into their own company, but at some point, they'll be left with more cash than they can productively spend. This can lead to inefficient allocation of resources and a shrinking of the overall economic pie.

Buybacks allow shareholders to reinvest in the next growing company, which can be more beneficial than investing in a stagnant company.

Buybacks often receive preferential tax treatment compared to dividends in certain jurisdictions, where they are taxed as capital gains while dividends are taxed as ordinary income.

This tax treatment can make buybacks a more attractive option for investors, who may prefer to receive them over dividends. In India, for example, the government initially levied a dividends tax on corporates in 2014, prompting a surge in buybacks.

The tax disparity was later rectified in 2019, when the government equalized the tax treatments of dividends and buybacks on corporates. Buyback levels subsequently returned to pre-2014 levels.

On a similar theme: Share Repurchase Excise Tax

Stock buybacks have been criticized for enabling executive compensation gaming, where management inflates earnings per share to hit quarterly targets and boost their own compensation metrics.

More than 30 percent of all compensation plans were linked to EPS as recently as 2019, according to Institutional Shareholder Services (ISS).

This can be done by using buybacks to reduce the denominator (shares outstanding), boosting EPS in the short run, but it's hard to sustain in the long run.

Companies create more value through organic revenue growth and margin improvement, not by artificially boosting EPS.

Companies use buybacks to signal that their stock price is undervalued, but this method is not as committed as dividend signaling.

This approach is particularly effective for small-cap companies due to information asymmetry, which makes it harder for investors to access accurate information.

Academics have posited that buybacks can be a more effective signaling method for small-cap companies than for larger companies.

In the US, corporate leaders are paid significantly more than their counterparts in other parts of the world. A Bloomberg analysis found that the worker-to-CEO pay ratio is much higher in the US compared to other places.

This disparity is particularly striking given that a major predictor of a company's stock performance is largely beyond executive control. Even moderately competent leaders can appear to be doing well in a context where most stocks are rising.

The buyback phenomenon has led to a situation where CEOs are rewarded for short-term gains, rather than long-term investments. This is in contrast to dividends, which encourage shareholders to hold onto their stocks for the long haul.

The role of buybacks in exacerbating income inequality needs to be better understood.

Employee trading is a concern surrounding buybacks, as it can be used by insiders to manipulate the stock price. A 2018 US Securities and Exchange Commission (SEC) study found that insiders were twice as likely to sell on the days following a buyback announcement as they were in the days leading up to the announcement.

Executives can use buybacks to their advantage by announcing a buyback, then selling their shares a few days later. This is allowed under current US regulations, which prevent employees from trading on the same day as a buyback announcement.

In jurisdictions such as the UK and Japan, regulations mandate that all employee transactions be disclosed by the end of the next day, with no trading in the weeks or months leading up to closing periods. This makes employee trading actions much more difficult.

Insider trading can have a negative impact on long-term stock performance, as seen in a 2018 US SEC study that found companies where insiders sell heavily deliver subpar returns in the long term.

Additional reading: What Does Trading Stocks Mean

Income inequality is a pressing concern, and buybacks are often seen as a contributor to this issue. Evidence is mixed, but academics argue that buybacks can be used as a short-term fix to boost profitability metrics, taking away capital from workers for executive gain.

Regulators have lamented the large increase in stock buybacks, which has led to a decline in gainsharing of corporate profits with workers and growing inequality. This is a worrying trend, as it suggests that buybacks are being used to benefit a select few rather than the wider workforce.

McKinsey & Company research found that there is no empirical difference between whether distributions take the form of dividends or share repurchases, which means that buybacks could be no worse than dividends at contributing to income inequality. This raises questions about the underlying structure of share ownership rather than the buyback process itself.

Companies need to consider the implications of a buyback on their strategy and performance, as it can affect how they allocate resources and make decisions.

A buyback can impact executive compensation, as it can be seen as a way to boost short-term stock prices and increase executive bonuses.

Companies should evaluate a buyback on its merits, taking into account its potential effects on their investor relations communications.

Regulators and policymakers can examine their jurisdictions' stances on tax treatment, executive trading, and disclosure when evaluating buyback activity. This is crucial in determining whether stock buybacks should be illegal.

In evaluating buyback activity, regulators and policymakers can look at how different jurisdictions handle tax treatment, which can impact the financial health of companies. For instance, some jurisdictions may exempt buybacks from taxes, while others may not.

Regulators and policymakers can also consider the potential impact of buybacks on executive trading and disclosure. For example, regulators may scrutinize whether executives are using buybacks to enrich themselves at the expense of shareholders.

Here's an interesting read: Stocks in Trading

Regulators and policymakers have a crucial role in shaping the landscape of buyback activity. They can examine their jurisdictions' stances on tax treatment, executive trading, and disclosure to better understand the impact of buybacks.

In some jurisdictions, buybacks receive preferential tax treatment, leading shareholders to prefer them over dividends. This disparity can be rectified by equalizing the tax treatments of dividends and buybacks, as India did in 2019.

Regulators can also consider how to reconcile offering tax advantages with existing anti-buyback rhetoric from lawmakers. This is particularly relevant in jurisdictions like the US, where buybacks enjoy favorable tax treatment despite being disparaged by authorities.

Buybacks, or share repurchases, have a complex history. They were all but banned in the US during the 1930s due to concerns about market manipulation.

In 1982, the SEC adopted Rule 10B-18, also known as the safe-harbor provision, under the Reagan administration. This change allowed buybacks to be reintroduced in the US, leading to wider adoption around the world over the next 20 years.

The use of buybacks in non-US companies grew from 14 percent in 1999 to 43 percent in 2018. This significant increase in popularity of buybacks suggests a shift in corporate strategy.

Companies in the US are the leaders in buyback activity, and they spend more on buybacks than on dividends. In fact, the US is the only country where money spent on buybacks exceeds dividends.

The mechanisms for buybacks vary by jurisdiction, with some countries allowing shareholders to vote on the plan at an annual general meeting.